How Best to Maximize Cash Out from High Equity Triplex

12 Replies

I have held a triplex in Berkeley since 2002. It was the third property I purchased. It has about $2 million equity and a $550K principal balance. It is like a very extended BRRRR. I am finally ready for the refinance step (with beaucoup cash out) but have a somewhat unique problem: too much equity. Admittedly, not a bad problem to have.

The first mortgage broker I spoke with told me a cash out jumbo was not practical at this time, and that under a conventional refi, the most I could cash out would be $600K (at 44% LTV). I was hoping to cash out about $1.3 million (at 70% LTV). I want that other $700K or more.

I think conventional FHFA loan limits are specified here:  http://www.loanlimits.org/california/

My plan was to cash out and start investing in out of state rental properties.  I also co-own a nearby single with siblings.  My share of the equity is about $500K.  

Aside from selling my triplex via 1031, what are my options for maximizing cash out? Are there any clever ways to liberate my equity as cash? Condoing is difficult in Berkeley - has anyone put a "C" into BRRRR?

My appreciation in advance for your responses to this, my first post.

@Greg San Martin Congrats on having such a deal. Banks are nervous, very nervous right now. How many lenders have you spoken with?  If you could pull the cash, would the property still cashflow for you well?  I'm guessing not because rents probably aren't rising with the asset value. 

My gut (and quick peek at the numbers) tells me that you should sell and purchase in another market where you can make your dollar go further.  You could buy a portfolio of properties or a small multi-building.  Start playing Monopoly in real life!  PM me if you have Q's!

Thanks Whitney Hutten for that relevant podcast! If financing does not work, I may have to sell and we may end up traveling similar paths in different timeframes. I look forward to hearing how well your BRRRR'vestments weathered the Pandemic (in a follow up podcast or offline). I think David Greene and Brandon Turner may agree that Covid increases the relative attractiveness of residential vs commercial investing. It would be nice to learn how well BRRRR portfolios and strategies perform in the wake of the Pandemic.

Selling would require a 1031 to avoid a $600,000 tax hit. I am concerned that an exchange might limit my reinvestment options (making my first BRRRR investment more risky than this noobrrrr feels comfy with). A 1031 with almost all of my equity and net worth would presumably limit my cash flow potential, too, like an IRA. Would it?

Perhaps my first thought was wrong.  I initially thought I should cash out as much as possible into an out of state investment or syndication and then use the new cash flow to finance a series of house hacks back at the triplex.  Perhaps the better strategy is to house hack first and then use the cash flow from that hack to invest out of state or to get a better cash out loan.  Is there a good rule of thumb, analysis, paper or podcast on this gating choice?  Opinions please.

My triplex property is on a lot large enough to allow a 4th conventional unit under existing zoning.  That 4th unit would increase the cash out ceiling by $300K under Fannie Mae's lending guidelines (increase from $600K to $900K cash out).

Under new state law (California), I am allowed to put in two detached ADUs and a third ADU in my converted walk-in basement. The 3 ADUs would be ministerial permits (no neighbor approval required). Assuming pre-covid rents return by early 2021, each of those new units would cash flow nicely with the first rent check. All of these units would have separate entrances and no hallways, no shared central heat or air, no shared bathrooms, etc. (i.e., no infection corridors).

There are risks with holding the triplex.  For example, tech employees and Cal students could decide to leave Berkeley and never come back. Rents might decline.  If I spend too much time or money house hacking, I may miss really great buy opportunities in 2021 and 2022.  It is not clear yet whether a 3- or 4-plex with a few ADUs would be appraised as a residential property or as a commercial property.  ADUs may substantially limit the pool of buyers due to FHFA guidelines (see a different post in the future on this issue).  The maximum cash out at conventional rates might not be enough to complete the planned construction.  Local governments in the Bay Area have governance issues and seem far more likely to go bankrupt.  They may go on a rental property tax binge to bail themselves out.  Credit could become tighter even if rates stay flat.  And the x factor is that Covid makes all of these risks and others more volatile and harder to predict.  

Assuming I go with a house hack first, then what do you think of the following strategy?  Get a construction or hard money loan for $600K (presumably feasible).  Build and rent the 4th unit + 2 detached ADUs (the basement unit would have to wait to be developed due to cost).  The big financing questions remain: How long after my first rent checks were deposited would a bank be willing to refinance my mortgage + my construction loan(s) (combined total of $1.15 million)?  What is the risk that they would decline my refinance loan?  

After converting the triplex into a 6-plex and increasing free cash flow to $10,000 per month (assuming pre-covid rents and vacancy rates), what are my chances of qualifying for a jumbo refi with cash out? What income threshold, DTI and/or other criteria would I need to meet to qualify for a jumbo refi with cash out? Qualifying for a jumbo refi with cash out would help me achieve my primary objective, which is to increase my LTV at the triplex to well north of 50% so as to bankroll my out of state investments (and perhaps some in state investments, too).

Berkeley has the highest SFH appreciation rate for this century at ~$4k/month for the last almost 20 years. The average home has appreciated almost a million dollars this century. https://www.investorideas.com/...

I do not know what you are expecting with OOS RE investing but it is very unlikely that any market you choose will produce the return that you have been achieving in Berkeley. 

Add to this that CA has very low property tax increases.  Your Property tax rate on this property could easily be close to $20k less than if you purchased the property today. 

There is no way I would sell such a property.  I would die with it and with the current tax rules the value would have a new basis of the value at the time of my death for my heirs.   I would not be paying the taxes on that $2m of appreciation and I would not be resetting the property tax basis. 

Think about the value of the current property tax basis before choosing to sell.  You likely would be giving up on over $1.5k/month of tax savings. 

Good luck

Ok, a few more words ;)

1- I highly suggest you keep this long term, and work to maximize the added units. Ideally adding the 4th (regular) unit, and then the ADUs. All as practical as possible. These are great long term investments!

2- besides the main refi, you can always look at adding a 2nd loan, or a heloc on top. That will help you leverage your equity. Explore all options thoroughly, but don’t get overly concerned with squeezing every last dollar out. Better to leave some equity and do the above added units, then sell, be restricted by a 1031 timeline, and also deal with unknown areas in lesser out of states areas. Don’t let the tail wag the dog :)

3- My guess is that after you go 5+ units (even if ADU's) it will be considered a commercial loan, so easier to pull more cash out. BUT keep in mind that commercial loans have different terms and standards. Personally I prefer keeping to 4 units and getting a conventional 30 year fixed loan, especially now with super low rates, as I hold long term. (So personally I would add the 4th "standard" unit, max that loan, then add the ADU's and not refi. But that's me.) Commercial loans are normally 5,7, or 10 years fixed terms, or 15 years overa 15 year term.

Let us know what you decide to do by updating this post! Good luck

@Greg San Martin Jumbo refi’s are difficult right now. You can look at some larger banks like HSBC that do them frequently. I’d also recommend talking to your banker.

As a side note, you can definitely outperform 3% appreciation with investments outside of Berkeley.

For example, you can find 8-10% cap properties in the Charlotte metro that will have much stronger cashflow. They will still appreciate 3-4% per year and you still benefit from amortization and depreciation.

Thanks to all for great input!  I summarize the input as follows:

SELL vs HOLD & HACK

Nobody thinks selling/exchanging right away is a good strategy (what was I thinking?).  Some believe I should hold it permanently while others think I should wait until the hacks are complete to decide.  Dan notes that I need to carefully consider the real estate tax consequences of selling given California's favorable Prop 13 rules.  Amit's chart is worth a thousands words (each telling me the same thing: stop worrying about home values).  I found more reading and pics from same source:

https://www.bayareamarketreports.com/trend/3-recessions-2-bubbles-and-a-bab

And one excerpt (the table) from that great link Dan provided:

CONVENTIONAL vs JUMBO REFI/CASHOUT vs SECOND LOANS

The consensus is that I should get what I can with a refi/cash out. Amit observes the important difference between rates on residential vs commercial properties, and suggests retaining the last residential loan rather than a commercial loan. Amit goes on to suggest that a HELOC or second loan can then be used to tap into even more equity than a conventional loan might allow. Given the prospects for low interest rates over the long term, that seems like really great advice.

Jim confirmed that Jumbo refis are difficult right now but suggested that I keep looking. He identified HSBC as one bank that I could investigate.  I might not need a jumbo refi with cash out until all construction is completed, rents are seasoned and cash reserves are mature.  Time may loosen up the purse strings on jumbo refis.  

CONDOS

No input.  This seems like a no go any way given that local rules effectively prohibit condos.  

OUT OF STATE vs IN-STATE INVESTMENTS

Dan noted that no investments are likely to produce the return in Berkeley over the past 20 years.  I agree but I can hear the hips of the San Andreas fault creaking under my house at night.  One earthquake could convert my $2 million in equity into a default and bankruptcy.  I do not expect the same return if I stay in Berkeley.  Nor do I need the same return if I leave Berkeley or California.  My goal is to diversify my investment from a single basket (currently) so that I reduce the risk of losing everything.  When and if Martial law is declared following the big one, I MUST be able to move to one of my future properties in Boise, Raleigh, Provo, Phoenix, Charlotte, Portland, Seattle, etc., and watch the great recovery from afar.  Over a term of less than 20 years, Jim observes that I could do better than 3-4% in many locations.  For example, Jim says I can get 8-10% cap properties in the Charlotte metro that will have much stronger cash flow and still appreciate at 3-4% per year.  Coincidentally, about 20 years ago, I walked all over Charlotte looking for real estate.  It was one of the few places I have been that felt like home.   

UPDATED STRATEGY

Based on input thus far, here is my updated strategy:

  • Use cash and a construction loan (if needed) to build and rent a 4th conventional unit
  • Refi at conventional rates (original mortgage + construction loan + up to $900K cash out for a 4-plex)
  • Build and rent 2 ADUs using cash out
  • Build and rent basement ADU with HELOC, construction loan, or cash out
  • Start an ADU building business (there are at least 1,000 homeowners like me in Berkeley - I will meet each one)
  • BRRRR small properties or syndications to cut my teeth with any remaining cash out
  • Consider whether selling or exchanging makes sense once all rents are seasoned
  • Use accumulated cash flow to buy smaller properties or syndications to establish teams in key cities
  • Keep my eyes peeled for jumbo cash out loans to enable much larger RE investments down the road
  • Shield all RE investments from liability stemming from potential catastrophic losses to highly leveraged triplex in California

Lastly, it will take a while but I intend to report back with successes and lessons learned as I move down my bucket list.  

Thanks again to all who contributed,

BRRRRzerkeley Greg

@Greg San Martin good summary. I’ll add:

1- regarding earthquake risk, I’ve given that a lot of thought too. My main conclusion is that I only want to hold properties that are, A- not on/super close to the fault lines (in SF I’m about 7-12 miles away). B- seismically upgrade my properties (sheer walls, anchor bolts as a minimum). C- make sure I’m not on landfill. Given that, I think I’ll only sustain damage in an 8.0ish earthquake. Of course all bets are off if it’s 9.0+, but that’s unprecedented for this area. That starts to speculate along the lines of getting hit by a massive meteorite, earth spinning out of orbit, etc. 

But yes, I hear you about diversification. A year or two ago I gave some thought to selling a building or two, and 1031 exchanging into commercial NNN out of state. But I didn't think it was worth it, and I didn't feel that NNN was attractive enough- the safest had middling returns with little rent upside on long term leases, and the more aggressive ones had either short leases and/or riskier tenants. And even back then, the security of NNN was suspect in my mind, given that formerly huge companies like toys R us, Sears, Blockbuster, etc. have gone bankrupt. Of course with corona, the security of NNN has been further shattered. Don't get me wrong, someone who is well versed in commercial can probably still find the good properties today. But that's not me. I know San Francisco residential very well, not out of state commercial. So basically I'd rather deal with the devil I know, as I have so many work arounds in my war chest, given all the experience I have in this market.

2- what exactly is the process for condo conversions in Berkeley? I only know SF’s, as I’ve converted several of my properties, and yes, it was definite worth it (though lots of nuances to delineate.)

I am totally unfamiliar with Berkeley's condo conversion process.  But, I'll bite.  I suspect the strategies in Berkeley, Oakland, and SF are similar - make it so difficult to be a successful landlord that landlords will gladly pay exorbitant "fees" (i.e., taxes) to do condo conversions.  I speculate. 

The City of Berkeley's most recent annual condo report, dated December 2019, is located here.

Table 1 shows prima facie that Berkeley's condo conversion ordinance effectively prohibits condos in Berkeley.  There was one application (for a triplex) filed in 2019 and two applications approved for a total of 4 units.  I am pretty sure that at least hundreds of Berkeley landlords would want to exit the housing provider business if condo conversions were not effectively prohibited.  

Table 2 (see link) shows that the one triplex applicant in 2019 paid $60,000 in fees for two units.  $30,000 does not seem bad for me if I am selling one unit for $1 million.  But unfortunately, the math does not work that well.

The City codes in Berkeley are located here.  I scanned these codes for a few minutes and found the following:

Section 21.28.080 B.2. If the property contains three or more units, the affordable housing mitigation fee for each unit shall be capped at 8 percent of the sales price of the unit.  

So, if I were allowed to sell all of my units for $3,000,000, the 8% tax (i.e., "affordable housing mitigation fee") would be $240,000.  Or if I sold one unit for $1 million (more likely), I'd pay an $80,000 fee. 8% really does not seem too bad for me, but would I still be able to 1031 the proceeds?  If not, then I'd have to pay tax on about $700,000 in gains and I am not married so only the first $100K would be zero tax (i.e., the sold unit would be about 40% of the property value and 40% of $250K is $100K). So roughly $200K in taxes on the gain.  I think when all costs were factored in, I might end up paying 35-40% of the sales price in fees to the city and tax collectors.  So, I too would just say nyet to Berkeley condo.  

Please elaborate on how you made condo conversions work in SF.   

@Greg San Martin , Feasibility I can't speak to.  But if you converted those three units then in the eyes of the IRS you would own three distinct pieces of real estate.  And if you sold one you could 1031 the net sale of that into new investment property of any type anywhere.

In your case the net sale would be the $1 mil minus closing costs minus that affordable housing mitigation fee.  So your 1031 would probably end up being on a net sale of around $850K or so.  

The thing to be careful of is the perception that you are "creating inventory" in that conversion process.  A general rule of thumb is that as long as the conversion is on paper only and is addressing density/zoning, or legal description that you're not acting as a developer.  Check with your attorney doing the conversion to make sure they can move forward that way.

@Greg San Martin   As another poster said....banks are very very nervous right now. They send solicitations asking potential buyers or refinance prospects to do something....but their criteria they are making folks jump through are more strenuous then ever. Try to reach out to @Chris Mason as he is a great resource with this right now.

@Greg San Martin in SF it’s actually pretty straightforward IF it’s a 2 unit building. It needs to be owner occupied for 1 year then it qualifies. The process is pretty arduous and takes a year. And yes, different city departments take a bite out of your hide! You pay public works, planning and building dept fees, they inspect and nit pick Whatever they feel. And you have to prepay Your property taxes 1 year in advance.

The city used to allow 3-6 units to condo convert, but it was limited to 200 units a year. When that got backed up they instituted a wonky “lottery” system (of course you had to pay a fee every year to enter the lottery). When that started averaging 22 years until you get lucky and “win” The lottery, they created a bizarre “expedited” conversion to allow all those stuck in the lottery to convert. Of course they created extra (and $ large)“impact” fees for that pleasure. And lastly they abolished all future 3-6 unit conversions altogether.

Yup, SF  really encourages condo conversions!